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Dec 11, 2023

What Is a Stock Buyback?

By Team Stash
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brown paper shopping bag to represent 'buying back' company stock through a stock buyback

A stock buyback is when a public company repurchases shares of its own stock from shareholders, usually on the open market, reducing the total number of outstanding shares. 

Stocks are units of ownership of a company. By buying back shares owned by investors, companies are, essentially, re-purchasing themselves. A stock buyback is often called a share buyback, share purchase authorization, or share repurchase. Stock buybacks have been on the rise in recent years: in 2022, stock buyback announcements reached a record $1.22 trillion

In this article, we’ll cover:

How do stock buybacks work?

Most of the time, companies repurchase stock from shareholders on the open market, at market value. A company performing a stock buyback will generally announce a “repurchase authorization” alongside how much money they’re allocating to buying shares or the percentage of total shares they’re looking to purchase. 

Investors are under no obligation to sell back their stock. The company buys from those who want to sell, just like any other investor would. These shares are then purchased and “removed” from the market, and that ownership is reabsorbed into the company. 

A company will generally use its own money to repurchase stock, but it could also borrow cash for a stock buyback, though it’s a higher risk. And, despite having an authorization in place, there’s always a chance that the company doesn’t go through with the buyback should other priorities arise. 

Why do companies buy back their stock?

Companies issue a stock buyback for several reasons, but the primary goal is to create value for shareholders by raising share prices and increasing the company’s value on paper. 

Stock prices are driven by supply and demand. By reducing the number of available shares (supply), companies increase demand. More demand can drive higher stock prices, boosting value for shareholders.

Stock buybacks also impact a company’s balance sheet. The shares the company buys back are either canceled or held in treasury, not counted as outstanding stock. Having fewer shares on the market increases the earnings per share (EPS) and the price-to-earnings ratio (P/E ratio). Both are data points that help investors understand a company’s value and performance. 

Beyond simple valuation, stock buybacks offer companies several additional benefits.

  • Consolidate ownership: A stock represents partial ownership in a company and usually comes with voting rights and claims to capital. By issuing a stock buyback, a company reduces the total number of owners with these rights. 
  • Boost share prices: If a company feels that its shares are undervalued, it may repurchase stock to increase demand and boost investor confidence. If a company is worth the same amount as before but split into fewer pieces, each remaining shareholder now has a bigger piece of the pie. 
  • Attract more investors: Stock buybacks can be seen as a sign of management confidence in future performance. After all, why would a company buy back stock they expect to decrease in value? This display of optimism can attract future investors.
  • Increase flexibility: Stock buybacks are a more flexible way to return cash to shareholders than paying dividends. Dividends are paid on an ongoing basis,  and they’re a long-term strategy for providing shareholder value. Stock buybacks, on the other hand, are one-offs, so they’re easier for companies to control.

Is a stock buyback a good thing?

Stock buybacks can be a good thing, but they can also come with drawbacks for companies, employees, and investors if mismanaged. 

Is a stock buyback good for companies?

Stock buybacks allow companies to consolidate ownership, increase a stock’s demand, and possibly improve their valuation. By buying back shares, the company is paying off investors and reducing the overall cost of capital, especially if they offer dividends. On paper, a buyback often looks like a good idea. 

When mismanaged, a stock buyback can backfire for the company. By spending money on a buyback, a company isn’t investing in other ways that could improve the business or increase efficiency. The improved EPS and P/E ratio is just on paper, and the increase is often temporary or inflated. It can make a company’s earning potential appear better than it actually is. And if a company borrows money for a stock buyback, there’s always the risk that the debt could negatively affect their finances down the road. 

Is a stock buyback good for employees?

Stock buybacks could be good or bad for employees depending on the company, its financial situation, and how they provide benefits to their employees. When stock is a part of total compensation, employees of public companies often own a fair amount of their company’s stock. Because they are both investors and employees, they can benefit when a company buys back their stock at a good value, whether they sell or hold onto their stock at a higher price.

But stock buybacks mean that companies are investing money in the buyback that they could theoretically use elsewhere in their budget, like for employee compensation or reinvestment in the business. If the company is using a stock buyback to artificially bump up a company’s earnings, it could negatively impact employees. 

Is a stock buyback good for investors?

Just like employees and companies, stock buybacks can be good or bad for investors. It all comes down to whether the increased stock value is meaningful or artificial and temporary. 

In the short term, investors will see an increase in stock prices because the total number of available stocks has decreased. But that doesn’t necessarily mean that the company is performing any better than before. The money companies are reinvesting in their stock could be used to grow or increase efficiencies. There’s also a chance that the increase in share value could be temporary if the buyback is artificially inflating prices.  

Additionally, many companies provide stock to executives as part of their compensation. In some cases, company leaders might use a buyback to temporarily boost share prices in order to secure a bigger gain on their stock options. This may not necessarily be in the best interests of other shareholders. 

Investors should look at the company’s performance, any available plans, and the results of past buybacks when deciding whether to sell or hold onto their stock. If the company is buying at a premium price and you believe the company is continuing to work toward improving shareholder value, it may make sense to stay invested. If you believe the share price is overvalued or you don’t have confidence in the company’s future growth, a stock buyback may be an opportunity to sell.

Start participating in the stock market

A stock buyback only affects investors who already own shares in the company. You may or may not encounter a buyback as an investor, but it’s good to be prepared by understanding how stock buybacks work. In fact, getting to know key investing terminology can come in handy no matter where you are in your investing journey. With a focus on investing for the long term and keeping yourself educated, you can pursue a strategy that makes sense for your financial goals. 

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Written by

Team Stash


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